# Chapter 3

Interest and Equivalence

Copyright Oxford University Press 2011

Chapter Outline

Time Value of Money
Interest Calculations
Cash Flow Equivalence
Single Payment Compound Interest
Formulas
• Nominal and Effective Interest Rates

Copyright Oxford University Press 2011

Learning Objectives
• Understand the concept of “time value of
money”
• Distinguish between simple and
compound interest
• Understand the concept of “equivalence”
of cash flows
• Solve problems using Single Payment
Compound Interest Formulas
Copyright Oxford University Press 2011

• Current process resulted in significant scrap and tablet press downtime.Vignette: A Prescription for Success • A pharmaceutical company manufactured a prescription drug.4%) Production was reduced to 2 shifts (3) 240 batches processed in one year First year savings of \$10 million Copyright Oxford University Press 2011 . • Impact of the modifications: – – – – – Each batch finished in 16 hrs (24 hrs) Product yield increased to 96.6% (92. • Modification to the 3 presses cost \$90.000.

000 investment? (assume 4. What is the value of one batch of product? • How many batches needed to break even on the initial \$27.Vignette: A Prescription for Success • One year of production had a value of \$240 million. what is the present value of the project? (Assume interest rate of 15%) • If one batch is produced per day.000 investment is considered to occur at time 0. how often are the savings actually compounded? Copyright Oxford University Press 2011 . and the entire \$90.2% yield improvement) • If the first year savings is considered to be a single endof-year cash flow.

or • Receive \$1000 10 years from today? • Answer: Of course today! • Why? • I could invest \$1000 today to make more money • I could buy a lot of stuff today with \$1000 • Who knows what will happen in 10 years Copyright Oxford University Press 2011 .Computing Cash Flows • Question: Would you rather • Receive \$1000 today.

Copyright Oxford University Press 2011 .Computing Cash Flows • Because money is more valuable today than in the future. we need to describe cash receipts and disbursements at time they occur.

000 machine.Example 3-1 Cash flows of 2 payment options To purchase a new \$30. and \$6000 at the end of each of the next 4 years Copyright Oxford University Press 2011 . • Pay the full price now minus a 3% discount. \$8000 at the end of year 1. or • Pay \$5000 now.

000 1 0 1 -8.100 1 2 \$8.000 5 0 4 -6.000 3 0 4 0 3 -6.Example 3-1 Cash flows of 2 payment options Pay in 5 years Pay in full 0 End of Year Cash Flow End of Year Cash Flow 0 (now) -\$29.100 0 (now) -\$5.000 5 -6.000 1 2 3 4 5 0 \$5.000 2 0 2 -6.000 Copyright Oxford University Press 2011 3 4 5 .000 \$29.

000 at 8% interest in 2 years • Repay half of \$1000 plus interest at the end of each year \$1000 Yr Interest Balance Repayment 0 1000 Cash Flow 1000 1 2 -580 -540 80 40 500 0 500 500 0 1 \$580 Copyright Oxford University Press 2011 2 \$540 .Example 3-2 Cash flow for repayment of a loan To repay a loan of \$1.

Time Value of Money • • • • Money has purchasing power Money has earning power Money is a valuable asset People are willing to pay some charges (interests) to have money available for their use Copyright Oxford University Press 2011 .

3-1) Where P = Principal i = Simple annual interest rate n = Number of years F  P  P in Where F = Amount due at the end of n years Copyright Oxford University Press 2011 (Eq. 3-2) . and not on accrued interest Total interest earned = P in (Eq.Simple Interest Interest is computed only on the original sum.

Example 3-3 Simple Interest Calculation Loan of \$5000 for 5 yrs at simple interest rate of 8% Total interest earned = \$5000(8%)(5) = \$2000 Amount due at end of loan = \$5000 + 2000 = \$7000 Copyright Oxford University Press 2011 .

unless specifically stated otherwise Copyright Oxford University Press 2011 .Compound Interest • Interest is computed on the unpaid balance. which includes the principal and any unpaid interest from the preceding period • Common practice for interest calculation.

00 \$432.44 5 \$6.56 \$6.44 \$544.Example 3-4 Compound Interest Calculation • Loan of \$5000 for 5 yrs at interest rate of 8% Year Balance at the Beginning of the year Interest Balance at the end of the year 1 \$5.400.802.000.00 2 \$5.20 \$7.832.56 4 \$6.00 \$400.346.56 \$503.298.00 \$466.88 \$6.298.00 3 \$5.00 \$5.802.400.832.64 Copyright Oxford University Press 2011 .00 \$5.

00 5 \$1.00 \$1.00 \$160.00 \$80.080.000.00 \$1.080.000.00 \$5.00 \$1.200.00 \$3.00 \$6.00 \$1.000.00 \$320.160.200.00 \$400.000.000.00 2 \$4.000.00 \$240.00 \$1.00 \$1.00 \$1.240.160.00 \$160.320.00 \$1.00 3 \$3.00 \$4.000.00 \$320.00 \$80.00 \$1.400.00 \$1.00 \$5.00 \$400.00 Subtotal Copyright Oxford University Press 2011 .400.00 \$1.000.00 \$240.000.240.00 4 \$2.00 \$2.320.000.00 \$1.000.Repaying a Debt Plan #1: Constant Principal • Repay of a loan of \$5000 in 5 yrs at interest rate of 8% • Plan #1: Constant principal payment plus interest due Yr Balance at the Beginning of year 1 Interest Balance at the end of year Interest Payment Principal Payment Total Payment \$5.

00 \$400.00 \$400.00 \$400.400.Repaying a Debt Plan #2: Interest Only • • Repay of a loan of \$5000 in 5 yrs at interest rate of 8% Plan #2: Annual interest payment and principal payment at end of 5 yrs Yr Balance at the Beginning of year Interest Balance at the end of year 1 \$5.00 \$400.00 \$400.00 \$5.00 \$0.00 \$400.00 \$5.000.00 \$7.000.00 \$2.00 \$0.00 2 \$5.400.00 \$5.00 \$400.00 4 \$5.000.00 \$0.000.400.00 5 \$5.00 \$400.000.00 3 \$5.000.00 \$400.00 \$5.00 \$400.00 \$400.00 Subtotal Interest Payment Principal Payment Copyright Oxford University Press 2011 Total Payment .400.400.400.00 \$5.00 \$400.000.00 \$5.00 \$400.00 \$5.00 \$5.000.000.00 \$400.00 \$0.

52 \$92.00 \$852.65 \$1.65 \$2.15 \$178.41 Subtotal Interest Payment Principal Payment Copyright Oxford University Press 2011 Total Payment .76 \$1.25 \$258.252.233.28 \$1.485.073.76 \$1.28 4 \$2.18 \$994.28 3 \$3.252.28 5 \$1.00 \$400.63 \$1.54 \$331.82 \$920.10 \$1.252.000.411.227.28 \$92.72 \$331.159.479.261.18 \$3.41 \$5.82 \$4.252.52 \$1.147.252.252.00 \$5.261.43 \$258.28 \$1.28 2 \$4.Repaying a Debt Plan #3: Constant Payment • Repay of a loan of \$5000 in 5 yrs at interest rate of 8% • Plan #3: Constant annual payments Yr Balance at the Beginning of year Interest Balance at the end of year 1 \$5.000.46 \$1.00 \$400.00 \$6.400.159.80 \$178.

64 \$5.00 2 \$5.000.346.346.64 Subtotal Interest Payment Principal Payment Copyright Oxford University Press 2011 Total Payment .64 \$2.832.00 \$0.000.00 4 \$6.20 \$7.400.298.64 \$2.00 \$432.56 \$503.400.000.00 \$0.00 \$5.00 \$0.00 \$0.802.00 5 \$6.346.00 \$5.56 \$6.00 \$0.56 \$0.802.00 \$7.00 \$466.832.00 \$7.88 \$6.64 \$5.44 \$544.00 \$0.346.44 \$0.346.00 \$400.00 3 \$5.00 \$0.00 \$0.00 \$0.Repaying a Debt Plan #4: All at Maturity • Repay of a loan of \$5000 in 5 yrs at interest rate of 8% • Plan #4: All payment at end of 5 years Yr Balance at the Beginning of year Interest Balance at the end of year 1 \$5.298.00 \$0.

A Closer Look at the 4 Repayment • Differences: • Repayment structure (repayment amounts at various points in time) • Total payment amount • Similarities: • All interest charges were calculated at 8% • They all achieved the same purpose of repaying the loan within 5 years Copyright Oxford University Press 2011 .

it would have no preference about whether it received \$5000 now or was paid by any of the 4 repayment plans. • The 4 repayment plans are equivalent to one another and to \$5000 now at 8% interest Copyright Oxford University Press 2011 .Equivalence • If a firm believes 8% was reasonable.

one can convert different types of cash flows at different points of time to an equivalent value at a common reference point • Equivalence is dependent on interest rate Copyright Oxford University Press 2011 .Use of Equivalence in Engineering Economic Studies • Using the concept of equivalence.

at i. 3-4) n Find F. n) (Eq. over n Copyright Oxford University Press 2011 .Single Payment Compound Interest Formulas Notation: i = interest rate per compounding period n = number of compounding periods P = a present sum of money F = a future sum of money Single Payment Compound Amount Formula F  P(1  i) (Eq. 3-3) F  P(F/P. i. given P.

i.06)3 = \$595.50 0 1 i=6% P=500 2 3 Or F = P(F/P.50 Copyright Oxford University Press 2011 . n) = 500(F/P.Example 3-5 Single Payment Compound Interest Formulas \$500 were deposited in a saving account (pays 6% compounded annually) for 3 years F=? F = P(1+i)n = 500(1+0. 3) = 500(1.191) = \$595. 6%.

i. 3-6) . over n Copyright Oxford University Press 2011 (Eq. 3-5) (Eq. given F. at i.Single Payment Compound Interest Formulas Notation: i = interest rate per compounding period n = number of compounding periods P = a present sum of money F = a future sum of money Single Payment Present Worth Formula P  F(1  i) -n P  F(P/F. n) Find P.

4) = 800(0.05)-4 = \$658.16 Copyright Oxford University Press 2011 . 5%. n) = 800(P/F.Example 3-6 Single Payment Compound Interest Formulas Wish to have \$800 at the end of 4 years.16 0 1 2 i=5% P=? 3 4 Or P = F(P/F.8227) = \$658. i. how much should be deposited in an account that pays 5% annually? F=800 P = F(1+i)-n = 800(1+0.

i.5% n = 3 x 4 = 12 quarters 0 1 2 i=1.5% P=500 11 12 F = P(1+i)n = P(F/P.5%.12) = 500(1. compounded quarterly) for 3 years F=? i = 6%/4 = 1.1.00 Copyright Oxford University Press 2011 .Example 3-7 Single Payment Compound Interest Formulas \$500 were deposited in a saving account (pays 6%.196) = \$598.015)12 = 500(F/P. n) = 500(1+0.

Nominal and Effective Interest Rates Notation: r = Nominal interest rate per year without considering the effect of any compounding i = Effective interest rate per compounding period ia = Effective annual interest rate taking into account the effect of compounding m = Number of compounding periods per year r m m ia  (1  )  1  (1  i)  1 m r For Continuous Compounding ia  e  1 r i m Copyright Oxford University Press 2011 (3-7) (3-8) (3-9) .

0050% 1.0201% 3% 3% 3.1364% 6.0046% 1.5625% 27.1271% 6% 6% 6.1678% 6.0811% 5% 5% 5.0225% 3.0050% 2% 2% 2.4025% Copyright Oxford University Press 2011 .5171% 15% 15% 15.0339% 3.0184% 2.3287% 10% 10% 10.0100% 2.4429% 28.0604% 4.3278% 8.0455% 4% 4% 4.0151% 2.0201% 2.0808% 4.8650% 16.0400% 4.0732% 28.5625% 15.1837% 8% 8% 8.1834% 25% 25% 26.0416% 3.0755% 16.2432% 8.1162% 5.2500% 10.0038% 1.0945% 5.Nominal and Effective Interest (Table 3-3) Nominal Rate Effective Annual Rate when compounded Yearly Semiannually Quarterly Monthly Daily Continuously 1% 1% 1.0742% 4.3000% 8.0453% 3.1600% 8.0900% 6.3916% 28.4713% 10.1267% 5.0025% 1.0625% 5.1831% 6.5156% 10.3813% 10.1798% 16.

you owe me \$60 on the following Monday.” a) Weekly interest rate = (\$60-50)/50 = 20% Nominal annual rate = 20% * 52 = 1040% b) Effective annual rate ia  (1  i)m  1  (1  20%)52  1  1310400 % c) End-of-the-year balance F  P(1  i)n  50(1  20%)52  \$655.Example 3-10 Application of Nominal and Effective Interest Rates “If I give you \$50.200 Copyright Oxford University Press 2011 .

r. n  F(e rn ) Copyright Oxford University Press 2011 (3-16) . r. n  P(e ) rn (3-15) Single Payment Present Worth P  FP/F.Continuous Compounding Interest Formulas Single Payment Compound Amount F  PF/P.

34 Copyright Oxford University Press 2011 .051 271)2  \$2210.Example 3-11 Application of Continuous Compounding How much would be in the account for \$2000 deposit in a bank that pays 5% nominal interest.40 Or i  er  1  5.05 )( 2 )  \$2210. compounding continuously for 2 years? F  P(er n )  2000e( 0.1271% F  P(1  i)2  2000(1.

Example 3-13 Application of Continuous Compounding How long will it take for money to double at 10% nominal interest.10)n  ln 2  0.93 (1.693 n  6.105171) n  2 Copyright Oxford University Press 2011 .10 )(n )  2 (0. compounding continuously? F  P(er n )  e( 0.5171% F  1(1  i)n  2 n  6.93 years Or i  er  1  10.